What is a Contractionary Monetary Policy?

Definition: A contractionary monetary policy is an macroeconomic strategy used by a central bank to decrease the supply of money in the market in an effort to control inflation. The Federal Reserve and the government control the money supply by adjusting interest rates, purchasing government securities on the open market, and adjusting government spending.

What Does Contractionary Monetary Policy Mean?

The FED maintains a portfolio of government bonds, and Treasury notes, which are sold to commercial banks in exchange for securities. This strategy forces the banks to charge higher interest rates, thus causing a contraction in the money supply. Alternatively, the central bank can increase the discount rate. When commercial banks face cash-flow problems, they can exchange their short-term bills and foreign exchange notes with the central bank. This means to borrow at a higher discount rate from the central bank, which is actually exercising a contractionary monetary policy to limit the money supply.

A contractionary policy is used to decrease the money supply, so the FED would increase interest rates to discourage borrowing and decrease government spending to reduce the availability of money. This leads to higher interest rates, lower income, and a drop in demand, production, and employment.

The government exercises a contractionary monetary policy only when it seeks to slow down inflation or depress an impending economic bubble. This forces banks charge higher interest rates to anticipate the lower money supply, businesses contract their borrowing and cease expansion. This leads to higher unemployment and lower demand as consumer spending is depressed and the economy is tightened to the extent of recession.

Let’s look at an example.

Example

Within a year, inflation rises steeply from 2% to 14%, so the government institutes a contractionary policy by doubling interest rates from 6% to 12%. This action discourages borrowing and reduces the easy access to money that consumers and businesses previous had. Thus, inflation gets stuck between 12% and 14%, the prices of goods stabilize, and unemployment grows from 3% to 7%.

In an effort to control the inflation, the government decides to increase the interest rates again only up to 15% this time. This adjustment puts undue stress on the economy because now businesses are afraid to get new loans for expansion. Thus, unemployment rises to 9% and consumer spending decreases again. At this point the contractionary policy has taken effect and the government should move on to an expansionary policy.